Make sure your general partner liability insurance works as intended

September 2014 | SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2014 Issue

Last summer, the Sun Capital Partners case potentially opened the door to holding private equity firms liable for the underfunded pension obligations of their portfolio companies. Many fund sponsors and managers have subsequently been carefully reviewing their portfolio companies for possible funding issues, and also trying to avoid the circumstances that led the First Circuit to rule that Sun Capital could potentially be liable. The decision effectively undermined the protection that ERISA had historically provided to private equity funds for just such liabilities.

But the more familiar issues of professional liability, indemnity obligations, fiduciary liability and regulatory investigations still form the backbone of the risk management issues facing private equity firms. A properly constructed general partnership liability (GPL) insurance program can help both protect the fund assets and guarantee that the indemnification obligations of funds are met.

The basic issues to look at include which persons and entities you are looking to protect; which risks you are seeking to manage; whether other third-party insurance might cover some risks; which activities need to be covered; and whether you are better off with a single comprehensive policy or separate policies for separate risks.

In addition, it is essential to be certain that the policy definitions, terms, conditions and exclusions do not undermine the very purpose of your coverage.

Protected persons and entities

Typically, private equity firms are looking to protect their fund manager and general partner, as well as their constituent officers, directors, partners and employees. These are also the persons commonly covered by the firm’s indemnity obligations. GPL coverage will often therefore function similarly to a corporate directors and officers policy, with ‘Side B’ coverage that reimburses the firm when it fulfils its indemnity obligations, and ‘Side A’ coverage that directly protects the individuals should the entity be unable to provide the indemnity. The policy should also provide ‘Side C’ coverage for claims against the general partner by limited partners or their members.

Covered risks

The most commonly covered risks, fundamental to any reasonably drafted GPL policy, should include litigation brought by limited partners and some employment related litigation. GPL policies might also cover government investigations and compliance actions brought by the SEC or other agencies. In addition, coverage might be available for additional liabilities and risks such as suits by target companies or their management, suits by competing purchasers, various securities claims and also outside directorship claims – that is, where directors, officers or employees of the private equity firm also act as directors of portfolio companies. As a bonus, check for coverage for non-profit outside directorships so your executives and employees are covered while doing good.

Other available and potentially applicable insurance

The most likely source of other insurance (purchased by third-parties) is the D&O insurance of portfolio companies. This insurance should cover any employees for the same types of claims covered by the outside directorship coverage mentioned immediately above. It is also possible to be covered as an additional insured under contractual indemnity and insurance provisions included in your contracts with third-party vendors. In all such cases, have an experienced professional such as a broker or risk management consultant check the ‘other insurance’ language of all relevant policies to make sure the other insurance provides coverage before your own, which should only apply if the other insurance does not cover a particular claim or after its limits are fully exhausted.

Covered activities

If you expect some covered individuals or entities to be covered for claims arising out of services they provide, check to be sure that the definition of professional services or covered activities includes and matches their actual services and responsibilities.

Moreover, some GPL policies might include a professional services exclusion, which could eliminate such coverage altogether. Even with the purchase of separate professional liability coverage, there is no guarantee that it will provide seamless coverage with the executive liability portion of the GPL policy. It is advisable, therefore, to read such provisions closely with the advice and input of a broker before selecting coverage with a particular carrier or carriers.

Unified coverage or separate policies

As with most decisions, there are trade-offs in deciding whether to purchase a comprehensive all-in-one policy for executive liability, professional liability and employment liability, or rather to purchase separate policies, perhaps from different companies. A single policy might have a single set of shared limits for all coverage types, but this can sometimes be avoided by paying additional premium if you prefer. Separate policies can be more likely to create coverage gaps, but unified coverage is not automatically seamless. For example, purchasing executive liability and professional liability coverage from the same company is no guarantee that the definitions of professional service will match. It is not uncommon for a single insurance company to argue that a claim involves professional services where an exclusion is at issue, but not a professional service where a coverage grant is implicated. Assuming you even have a choice, which may or may not be the case depending on changing market circumstances, you can only check and compare the policy terms, and negotiate changes to align the coverage as much as possible.

Additional concerns and issues

Finally, a comprehensive policy review is required to check for hidden traps and exclusions. If you are concerned about claims among insureds (such as claims by limited partners against the general partner), make sure that the ‘insured versus insured’ exclusion does not negate coverage in that scenario. Ask that vague exclusions, such as those for coverage that violate public policy, be clarified and made specific. Better policies will require that the insurance company pay defence costs directly, rather than reimburse the policyholders on a recurring basis, or worse, after the case is over. Among other things, this helps protect individual defendants should the entity be unable to pay defence costs, perhaps in the case of bankruptcy. Similarly, portfolio company bankruptcy is another risk that should be expressly dealt with in the policy, clarifying that the GPL policy will step in immediately if a portfolio company becomes bankrupt and is unable to fulfil its indemnity obligations. The bankrupt portfolio company’s insurance can get mired in the bankruptcy, and claimed as an asset by the trustee. Moreover, claims by the trustee can also get caught in the ‘insured versus insured’ exclusion if it is not properly limited.

GPL insurance for private equity firms can be a real asset, but only if the coverage is real and not beset by holes. The time to discover any issues is before the language is set and coverage is placed.

Mark Garbowski is a senior shareholder at Anderson Kill P.C. He can be contacted on +1 (212) 278 1169 or by email: mgarbowski@andersonkill.com.